The surge in crude oil prices in the last decade has made jet fuel the biggest expense for airlines. Oil prices tend to be volatile, and so many airlines have adopted fuel hedging practices in order to offset their exposure to fuel price swings. Ideally, rising fuel prices will be offset by hedging gains, while falling fuel prices will be offset by hedging losses.

In practice, most airlines' fuel hedges don't work perfectly. Sometimes, that means that jet fuel prices go up without producing an offsetting hedge gain. Other times, airlines can benefit from a drop in jet fuel prices without bearing the offsetting cost of hedging losses.

Due to a fortuitous change in its hedging strategy, Hawaiian Holdings, (NASDAQ:HA) is on pace for a nice fuel hedging windfall this quarter. The company recently started using heating oil swaps as its hedging instrument of choice, and extremely cold weather in the Northeast has driven up heating oil prices. This will produce a hedging gain even though jet fuel prices haven't risen very much.

The pitfall of hedging
For an airline, fuel hedging involves buying and selling financial instruments that will move in the opposite direction from jet fuel prices. However, it is actually quite difficult to hedge jet fuel prices perfectly. There are active futures markets for crude oil and certain products like heating oil and gasoline, but not for jet fuel.

Delta bought a refinery in 2012 to better hedge against jet fuel price swings.

Jet fuel swaps are the only "perfect" hedge, but they tend to be expensive and illiquid. Delta Air Lines (NYSE:DAL) has implemented a unique response to this problem; in 2012, it bought a refinery, which it uses to produce much of its own jet fuel. (Between its crude oil hedges and its ownership of a refinery, Delta is protected against both major components of jet fuel prices: the price of crude and the refining premium.)

Other airlines make do with a variety of not-quite-satisfactory solutions. Alaska Air (NYSE:ALK) uses a combination of crude oil call options and jet fuel swaps to protect against spikes in crude oil prices or jet fuel refining costs. United Continental (NASDAQ:UAL) uses a variety of hedging instruments tied to crude oil, jet fuel, heating oil, and diesel fuel.  American Airlines (NASDAQ:AAL) is phasing out hedging, but it currently has some hedges in place tied to crude oil, jet fuel, and heating oil.

A nice surprise for Hawaiian Airlines
In recent years, Hawaiian Airlines has hedged only against swings in crude oil prices. In fact, all of its fuel hedges were tied to Brent crude prices as recently as early October. However, at the company's annual investor day later that month, Hawaiian CFO Scott Topping stated that the company was changing its hedging strategy in order to minimize the cost of hedging premiums.

As disclosed in the company's most recent quarterly results, Hawaiian Airlines closed out all of its hedges tied to Brent crude last quarter. Instead, the company's hedges now come primarily in the form of heating oil swaps. For the current quarter, Hawaiian has hedged 61% of its expected fuel consumption with heating oil swaps at an average price of $2.92 per gallon.

These heating oil swaps will pay off if the price of heating oil rises above $2.92 per gallon. Heating oil prices are usually a good proxy for jet fuel prices. In the last few years, the New York heating oil spot price has typically been $0.02-$0.05 below the Gulf Coast jet fuel price. By October -- when Hawaiian began its strategy shift -- the heating oil spot price was already $0.05 above the jet fuel spot price.

Since then, unseasonably cold weather has drained U.S. heating oil stocks. As a result, the premium for heating oil prices above jet fuel prices widened even further. By the last week of January, New York heating oil had soared to $3.205 per gallon, while Gulf Coast Jet fuel remained near $2.930 per gallon: a spread of $0.275!

Heating oil prices have since retreated, and the heating oil premium over the jet fuel spot price finally dropped back below $0.10 earlier this week. Still, depending on the settlement dates for Hawaiian's heating oil swaps, the company could get a big hedging payoff this quarter even though jet fuel prices have remained roughly flat.

A critical piece of the puzzle
The first quarter of the year is seasonally weak for airlines. Like many other carriers, Hawaiian Airlines can use all the help it can get to turn a profit in Q1 -- or at least minimize its losses. Last year, a combination of overcapacity in some markets, currency weakness in others, and high fuel prices led to a big Q1 adjusted loss of $0.29 per share for Hawaiian. Despite the high fuel prices, Hawaiian reported realized losses of $2.7 million from its hedges, aggravating its losses.

By contrast, Hawaiian's recent switch to hedging in heating oil and the subsequent spike in heating oil prices currently puts the company on pace for a hedging gain this quarter. Market jet fuel prices are also solidly lower than they were at this time last year. Lower fuel prices alone could help Hawaiian cut in half its Q1 loss from last year.

The difficulty of hedging jet fuel prices perfectly has dogged airlines in recent years. However, this quarter, Hawaiian Holdings should get a nice windfall thanks to the "freak" divergence of jet fuel and heating oil prices.

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